Question

Respond to each short answer question using two to three well-constructed paragraphs (150 – 250 words) containing specific details and examples that support your understanding of the concepts.

1. Explain how businesses can use price elasticity of demand to make decisions about whether to raise or lower prices.

Answer 1

Price elasticity of demand measures how much quantity demanded responds to a change in price. Price elasticity of demand (PED) = percentage change in quantity demanded / percentage change in price. There are five type of price elasticity of demand:-- 1. Perfectly inelastic demand - when (PED = 0) it happens when an increase in price leaves demand unchanged. This is the very rare case 2. Inelastic demand- when PED < 1. It happens when a greater change in price change the demand by fewer units. For ex a 10% decrease in price increase the demand by less than 10% for say 8%. 3. Unit elastic demand- when PED = 1. It happens when 10% change in price change the demand also by 10%. 4. Elastic demand - when PED > 1. It happens when 10% change in price changes the demand by more than 10% for say 12%. 5. Perfectly inelastic demand- when PED = infinity. It happens when a smaller change in price , quantity demanded changes infinitely. this is very rare case.

Business and firms can use this for making decisions because it explains the impact of price change on total revenue P × Q depends on elasticity of demand. When the demand inelastic (PED<1), an increase in price leads to a decrease in quantity demanded that is proportionately smaller, so total revenue increase. Thus there is positive relation . When the demand is elastic PED > 1, an increase in price leads to a decrease in quantity demanded that is proportionately larger so total revenue decreases. Thus there is negative relation. When the demand is unit elastic PED=1 , an increase in price leads to a decrease in quantity demanded that is proportionately equal so total revenue remain unchanged.

So by analysing price elasticity of demand business can decide to lower the price or increase the price. Demand is inelastic then increasing price is good decision because quantity demanded decreases less and it will increase revenue. If demand is elastic then decreasing the price is a good decision because quantity demanded increase more and revenue increase. If demand is unit elastic then change in price has no effect on revenue.